Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market
An American Enterprise Institute Policy White Paper

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Executive Summary

Many commentators have pointed out that the Dodd-Frank Act ignored the fundamental causes of the financial crisis it was supposed to address. While imposing new, costly and growth inhibiting regulations on the entire financial system, the act failed to reform the US government‘s housing policies—policies that fostered the creation of 27 million subprime and Alt-A loans and the inflation of a massive housing bubble between 1997and 2007. When the bubble began to deflate, these weak and high-risk loans started to default in unprecedented numbers, driving down housing values and weakening financial institutions in the United States and around the world.

Implicit in most of the proposals for reforming the housing finance system is the idea that institutional investors will not buy mortgage backed securities (MBS) backed by US mortgages unless they are issued by a government sponsored enterprise (GSE), a US government agency, or are otherwise guaranteed by the US government. We believe, however, that there is a robust alternative to government support of the housing finance system—a system which in the past has led to large scale taxpayer bailouts and losses. Our alternative approach is to ensure that only prime quality mortgages, which comprise the vast majority of US mortgages, are allowed into the securitization system. The very low delinquency and default rates on prime mortgages will be attractive investments for institutional investors and enable the housing finance system to function effectively with no government support. This will eliminate the potential for additional taxpayer losses in the future, and allow the eventual elimination of Fannie Mae and Freddie Mac.

In order to implement our approach, in this white paper we outline four basic principles on which US housing policy should be based in the future. If these principles had been in place for the last twenty years, we would not have had a financial crisis in 2008. But that is water over the dam. The current interest in replacing Fannie Mae and Freddie Mac provides another opportunity to adopt reforms that will prevent a recurrence of another financial crisis in the future.

The four central principles of our plan are the following:

I. The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should principally function without any direct government financial support.

Under this principle, we note that the huge losses associated with the Savings and Loan debacle of the late 1980s and Fannie and Freddie—as well as the repetitive volatility of the housing business—did not come about in spite of government support for housing finance but because of government backing. Government involvement not only creates moral hazard but also sets in motion political pressures for further and more destructive actions to bring benefits such as ?affordable housing? to constituent groups.

Although many new ideas for government involvement in housing finance are being circulated in Washington, they are not fundamentally different from the policies that have caused the failures of the past, including the substantial losses in the S&Ls and the losses still to come from Fannie and Freddie. The fundamental flaw in all these ideas is that the government can successfully establish an accurate risk-based price or other compensatory fee for its guarantees or other support. Many examples show that this is beyond the capacity of government and is in any case politically infeasible. The problem is not solved by limiting the government‘s risks to mortgage-backed securities (MBS); the government‘s guarantee eliminates an essential element of market discipline—the risk aversion of investors—so the outcome will be the same: the underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.

II. To the extent that regulation is necessary, it should be focused on ensuring mortgage credit quality.

This principle is based on the fact that high quality mortgages are good investments and have a history of minimal losses. Instead of relying on a government guarantee to assure investors of the quality of mortgages or MBS, we should simply make sure that the mortgages made in the United States are predominantly prime mortgages. We know what is necessary to produce a prime mortgage; these characteristics are outlined in this white paper. Before affordable housing requirements were imposed on Fannie and Freddie in 1992, these were the standards that kept credit losses in the mortgage markets from affecting the entire economy.

Experience has shown that some regulation of credit quality is necessary to prevent the deterioration in underwriting standards. The natural human tendency to believe that good times will continue—and ?this time is different?—will always spawn bubbles in housing, as in other assets. Bubbles in turn spawn subprime and other risky lending, as most participants in the housing market come to believe that housing prices will continue to rise, making good loans out of weak ones. Bubbles and the losses suffered when they deflate can be minimized by interrupting this process—by inhibiting the creation of weak and risky mortgages through appropriate regulation.

III. All programs for assisting low-income families to become home-owners should be on-budget and should limit risks to both homeowners and taxpayers.

The third principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must balance the interest in low-income lending against the risks to borrowers and the interests of the taxpayers. In the past, affordable-housing and similar policies have sought to produce certain outcomes—for example, an increase in home ownership—which turned out to escalate the risks for both the borrowers and the taxpayers. The quality of the mortgages made under social policies can be lower than prime quality—the taxpayers may take risks for the purpose of attaining some social goods—but there must be quality and budgetary limits placed on riskier lending in order to keep taxpayer losses within reasonable bounds.

IV. Fannie Mae and Freddie Mac should be eliminated as government-sponsored enterprises (GSEs) over time.

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so the private sector can take on more of the secondary market as the GSEs depart. The gradual withdrawal of the GSEs from the housing finance market should be accomplished by reducing the conforming loan limit by 20 percent each year, according to a published schedule so the private sector knows what to expect. These reductions would apply to the conforming loans limits for both regular and high-cost areas. Banks, S&Ls, insurance companies, pension funds, and other portfolio lenders would be supplemented by private securitization, but Congress should make sure that it does not foreclose opportunities for other systems, such as covered bonds.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI, Alex J. Pollock is a resident fellow at AEI, and Edward Pinto is a resident fellow at AEI.

Photo Credit: iStockphoto/dra_schwart

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About the Author


Peter J.


Alex J.
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.

    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.

    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.

    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.

  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org


Edward J.
  • American Enterprise Institute (AEI) resident fellow Edward J. Pinto is the codirector of AEI’s International Center on Housing Risk. He is currently researching policy options for rebuilding the US housing finance sector and specializes in the effect of government housing policies on mortgages, foreclosures, and on the availability of affordable housing for working-class families. Pinto writes AEI’s monthly Housing Risk Watch, which has replaced AEI’s FHA Watch. Along with AEI resident scholar Stephen Oliner, Pinto is the creator and developer of the AEI Pinto-Oliner Mortgage Risk, Collateral Risk, and Capital Adequacy Indexes.

    An executive vice president and chief credit officer for Fannie Mae until the late 1980s, Pinto has done groundbreaking research on the role of federal housing policy in the 2008 mortgage and financial crisis. Pinto’s work on the Government Mortgage Complex includes seminal research papers submitted to the Financial Crisis Inquiry Commission: “Government Housing Policies in the Lead-up to the Financial Crisis” and “Triggers of the Financial Crisis.” In December 2012, he completed a study of 2.4 million Federal Housing Administration (FHA)–insured loans and found that FHA policies have resulted in a high proportion of working-class families losing their homes.

    Pinto has a J.D. from Indiana University Maurer School of Law and a B.A. from the University of Illinois at Urbana-Champaign.

  • Phone: 240-423-2848
    Email: edward.pinto@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: 202-419-5212
    Email: emily.rapp@aei.org

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